International Business

Competing in the Global Marketplace

8e

By Charles W.L. Hill

Chapter 5

International
Trade Theory
 Why Is Free Trade Beneficial?
Free trade - a situation where a government
does not attempt to influence through quotas
or duties on exports and imports
Trade theory shows why it is beneficial for a
country to engage in international trade even
for products it is able to produce for itself
International trade allows a country
 to specialize in the manufacture and export of
products that it can produce efficiently
 import products that can be produced more
efficiently in other countries

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 Why Do Certain
Patterns Of Trade Exist?
Some patterns of trade are fairly easy to
explain
 it is obvious why Saudi Arabia exports oil,
Ghana exports cocoa, and Brazil exports coffee
But, why does Switzerland export
chemicals, pharmaceuticals, watches, and
jewelry?
Why does Japan export automobiles,
consumer electronics, and machine tools?
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 What Role Does
Government Have In Trade?
 The mercantilist philosophy makes a crude case
for government involvement in promoting
exports and limiting imports
 Adam Smith, David Ricardo, and Heckscher-Ohlin
promote unrestricted free trade
 New trade theory and Michael Porter’s theory of
national competitive advantage justify limited
and selective government intervention to
support the development of certain export-
oriented industries
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 What Is Mercantilism?

Mercantilism suggests that it is in a

country’s best interest to maintain a trade
surplus -to export more than it imports
advocates government intervention to achieve
a surplus in the balance of trade
Mercantilism views trade as a zero-sum
game - one in which a gain by one country
results in a loss by another

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 What Is Theory of
Absolute Advantage?
In his 1776 book The Wealth of Nations,
Adam Smith argued that a country has an
absolute advantage in the production of a
product when it is more efficient than any
other country in producing it
countries should specialize in the production of
goods for which they have an absolute
advantage and then trade these goods for the
goods produced by other countries

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 What Is Theory of
Comparative Advantage?
 In his 1817 book Principles of Political Economy,
David Ricardo asked what might happen when one
country has an absolute advantage in the
production of all goods
 Ricardo’s theory of comparative advantage
suggests that countries should specialize in the
production of those goods they produce most
efficiently and buy goods that they produce less
efficiently from other countries, even if this means
buying goods from other countries that they could
produce more efficiently at home

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 How Does the Theory of
Comparative Advantage Work?
 Assume two countries: Ghana and South Korea
Ghana is more efficient in the production of both
cocoa and rice
Ghana takes 10 resources to produce one ton of
cocoa, and 13 1/3 resources to produce one ton of
rice
So, Ghana could produce 20 tons of cocoa and no rice,
15 tons of rice and no cocoa, or some combination of
the two
In Korea, it takes 40 resources to produce one ton of
cocoa and 20 resources to produce one ton of rice
so, South Korea could produce 5 tons of cocoa and no
rice, 10 tons of rice and no cocoa, or some
combination of the two
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 How Does the Theory of
Comparative Advantage Work?
 With trade
Ghana could export 4 tons of cocoa to South Korea in
exchange for 4 tons of rice
Ghana will still have 11 tons of cocoa, and 4
additional tons of rice
South Korea still has 6 tons of rice and 4 tons of
cocoa
if each country specializes in the production of the
good in which it has a comparative advantage and
trades for the other, both countries gain
 Comparative advantage theory provides a strong
rationale for encouraging free trade
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Comparative Advantage and the Gains from Trade

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 Is Unrestricted Free Trade
Always Beneficial?
 Unrestricted free trade is beneficial, but the gains
may not be as great as the simple model of
comparative advantage would suggest
immobile resources
diminishing returns
dynamic effects and economic growth
 Opening a country to trade could increase
a country's stock of resources as increased supplies
become available from abroad
the efficiency of resource utilization and so free up
resources for other uses
economic growth

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 Could A Rich Country Be
Worse Off with Free Trade?
 Paul Samuelson - the dynamic gains from trade
may not always be beneficial
free trade may ultimately result in lower wages in
the rich country
 The ability to offshore services jobs that were
traditionally not internationally mobile may have
the effect of a mass inward migration into the U.S.,
where wages would then fall
 But, protectionist measures could create a more
harmful situation than free trade
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 What Is the Heckscher-Ohlin
(H-O) Theory?
Eli Heckscher and Bertil Ohlin - comparative
advantage arises from differences in national
factor endowments – the extent to which a
country is endowed with resources like land,
labor, and capital
predict that countries will export goods that
make intensive use of those factors that are
locally abundant, and import goods that make
intensive use of factors that are locally scarce

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 Does H-O Theory Hold?
Wassily Leontief theorized that since the U.S.
was relatively abundant in capital compared
to other nations, the U.S. would be an exporter
of capital intensive goods and an importer of
labor-intensive goods.
However, he found that U.S. exports were less
capital intensive than U.S. imports
Since this result was at variance with the
predictions of trade theory, it became known
as the Leontief Paradox

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 What Is the
Product Life Cycle Theory?
 The product life-cycle theory - (proposed by
Raymond Vernon in the mid-1960s) - as products
mature both the location of sales and the optimal
production location will change affecting the flow
and direction of trade
initially, new products would be produced and sold
in the U.S.
as demand grew in other developed countries, U.S.
firms would begin to export
demand for the new product would grow in other
advanced countries over time making it worthwhile
for foreign producers to begin producing for their
home markets
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 What Is the
Product Life Cycle Theory?
 U.S. firms might set up production facilities in
advanced countries with growing demand, limiting
exports from the U.S.
 As the market in the U.S. and other advanced nations
matured, the product would become more
standardized, and price the main competitive weapon
 Producers based in advanced countries where labor
costs were lower might now be able to export to the
U.S.
 If cost pressures were intense, developing countries
would acquire a production advantage
 Production became concentrated in lower-cost foreign
locations, and the U.S. became an importer

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The Product Life Cycle Theory

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 Does the Product Life Cycle
Theory Hold?
 The product life cycle theory accurately explains
what has happened for products like photocopiers
and a number of other high technology products
developed in the US in the 1960s and 1970s
 But, the globalization and integration of the world
economy has made this theory less valid today
the theory is ethnocentric
production today is dispersed globally
products today are introduced in multiple markets
simultaneously

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 What Is New Trade Theory?
 New trade theory suggests that the ability of
firms to gain economies of scale can have
important implications for international trade
1. Through its impact on economies of scale, trade can
increase the variety of goods available to consumers
and decrease the average cost
 with trade, markets are large enough to support the
production necessary to achieve economies of
scale; otherwise, nations might not be able to
produce those products
 so, trade is mutually beneficial because it allows for
the specialization of production, the realization of
scale economies, and the production of a greater
variety of products at lower prices
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 What Is New Trade Theory?
2. In those industries when output required to
attain economies of scale represents a
significant proportion of total world demand,
the global market may only be able to support
a small number of enterprises
 first mover advantages - the economic and
strategic advantages that accrue to early entrants
into an industry
 economies of scale
 first movers can gain a scale based cost
advantage that later entrants find difficult to
match

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 What Are the Implications of
New Trade Theory For Nations?
 It identifies an important source of comparative
advantage
a country may dominate in the export of a good
because it was lucky enough to have one or more
firms among the first to produce that good
 Most contentious implication is that governments
should consider strategic trade policies that
nurture and protect firms and industries where
first mover advantages and economies of scale
are important
at variance with the free trade philosophies
Boeing vs. Airbus
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 What Is Porter’s Diamond of
Competitive Advantage?
 Michael Porter tried to explain why a nation
achieves international success in a particular
industry and identified four attributes that promote
or impede the creation of competitive advantage
1. Factor endowments - a nation’s position in factors of
production necessary to compete in a given industry
 can be either basic (natural resources, climate,
location) or advanced (skilled labor, infrastructure,
technological know-how) factors
2. Demand conditions - the nature of home demand for
the industry’s product or service
 sophisticated and demanding customers pressure
firms to be competitive

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 What Is Porter’s Diamond Of
Competitive Advantage?
3. Relating and supporting industries - the presence or
absence of supplier industries and related industries
that are internationally competitive
 successful industries tend to be grouped in clusters in
countries and can spill over and contribute to other
industries
4. Firm strategy, structure, and rivalry - the conditions
governing how companies are created, organized, and
managed, and the nature of domestic rivalry
 vigorous domestic rivalry creates pressures to
innovate, to improve quality, to reduce costs, and to
invest in upgrading advanced features

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Determinants of National Competitive
Advantage: Porter’s Diamond

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 Does Porter’s Theory Hold?
 Two additional variables: chance and government
 Government policy can
affect demand through product standards
influence rivalry through regulation and antitrust laws
impact the availability of highly educated workers and
advanced transportation infrastructure.
 The four attributes, government policy and chance
work as a reinforcing system, complementing each
other and in combination creating the conditions
appropriate for competitive advantage
 So far, Porter’s theory has not been sufficiently
tested to know how well it holds up

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 What Implications for Managers?
1. Location implications - a firm should disperse its
various productive activities to those countries
where they can be performed most efficiently
 firms that do not, may be at a competitive
disadvantage
2. First-mover implications - first-mover advantage
can help a firm dominate global trade
3. Policy implications - firms should work to
encourage governmental policies that support free
trade
 lobby the government to adopt policies that have a
favorable impact on each component of the diamond

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 Review Questions
1. All of the following theories advocated free
trade except
a) Mercantilism b) Comparative Advantage
c) Absolute Advantage d) Heckscher-Ohlin

2. Which theory suggested that comparative

advantage arises from differences in national
factor endowments?

3. Which theory suggests that as products mature

the optimal production location will change?
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 Review Questions
4. Economies of scale and first mover advantages
are important to which trade theory?
5. ___________ refer to the nature of home demand for
the industry’s product or service.

6. Porter’s diamond of competitive advantage

includes all of the following except
a) Factor endowments
b) Related and supporting industries
c) First-mover advantages
d) Firm strategy, structure, and rivalry
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